Cash is like air; profit is like food. You need cash all the time, but you can survive, for a while, without profit. All employees must understand the difference between cash and profit to make the best decisions for your company.
Cash is the cash that flows in and out of a business during a specific period.
Vs.
Profit is revenue less expenses during a specific period.
Profit is essential for a business to grow. If no profit is generated over the long term, the business will see its original investment dwindle, and new investors will stay far away. If the business is lucky, a buyout will occur, and the company will likely disappear.
Overlooking your cash position is also a fatal mistake. Cash is necessary for the short-term survival of the firm.
The Danger of Confusing Cash and Profit
When you’re profitable, you tend to think in overly simplistic terms: “If I do twice as much of what I’m doing, I’ll make twice as much profit.” But the problem is that there will be a lot of cash going out for expansion—buying equipment, leasing premises, hiring people, developing a finished product. These additional expenses (cost of sales) are incurred months before you can start selling, not to mention that some customers or clients may not pay until months after a sale. You are then stuck carrying these costs or watching your profit margins decline.
The transition when a company is expanding and expending is perhaps the most dangerous time in business. Financial commitments arise, the company can’t raise enough funds, and it has to sell something at a loss to raise cash, winding up in a worse position than before.
Entrepreneurs, especially high-tech startups, have to prepare for the difficult period to extend beyond their initial projection. They must recognize that they will pump lots of cash into R&D and the startup costs of building something large-scale to make a profit.
At Income|Outcome, we experience this “cash vs. profit” scenario firsthand. When we bring on a new client, we pay a lot of expenses associated with training that client. We have to pay for consultants, printing, and travel costs, and we are obligated to pay people within 30 days if they’ve done work for us.
When a client doesn’t pay for six months, it’s a profitable sale, but we’re not seeing that cash (and those profits) coming in for quite a while. Meanwhile, we have all the expenses associated with that relationship. It isn’t easy, but it’s a consequence of expansion.
We must ensure a strong enough cash flow to stomach the interim period while we wait to be paid. Otherwise, our profits are a dream that won’t be realized.
How to Prioritize Cash and Profit
Avoiding a critical oversight of either cash or profit requires multiple things.
1) You Need a Strategic Plan
Where do you want to go? Where would you like to be? This is the “dreamer” or vision phase of business planning; it’s necessary, though certainly not enough to fuel a business.
2) You Need a Budget
Use a budget from your income statement to measure past profit and project it forward into the future. You must determine whether the business can be profitable before you worry about cash flow. Without profit, a business will never survive long-term.
You can use your profit and loss (P&L) statement from the last six months to determine a budget for the following six months.
3) You Need a Cash Flow Forecast
Budgets tell you if your expansion will be profitable and how much profit you will make. But they don’t tell you when cash is coming in. That’s where the cash flow forecast comes in.
Once you grasp how to handle your cash flow needs, your expectations will be as realistic as can be, and banks and investors will look more favorably on your business. They will know they’re dealing with someone who understands business and isn’t just a dreamer.
You should look at least a year down the line to know when and where cash will be flowing through your business. That way, you’ll know how much money will have gone out before your profitable sales start. It’ll tell you how much fresh funding you’ll need beyond the profits of the business and when you can afford to start your expansion if you’re going to self-fund. If there’s no way you can find the cash you need, you’ll have to go back and revisit your plans. Repeat each step until it works.
Cash and Profit Are Not the Same
The bottom line: cash is not profit, and profit is not cash. You need both to sustain and grow a business, though not in equal measures at every point.
You never start with the cash flow. The vision starts a business, profitability helps it grow, and cash flow is the day-to-day driver.
You can comfortably expand to a more profitable business as long as you have enough cash to survive. You won’t succumb to panic when the expansion takes longer than you thought, and you’ll eventually reap the benefits of greater and greater profits.
While these tips are a great start, basic financial acumen is required for all team members to achieve a healthy balance of cash and profits in a company. But, financial acumen can be challenging to build without training or real-world application. We offer financial acumen training to companies in all industries and employees at every level. Our Business Decisions & Results simulation and Finance & Decision Making simulation cover how to use various financial statements and forecasting in addition to other key learnings. They are fun, engaging and facilitate lasting behavioral change in participants. Now, you can rely on your employees to act in the best interest of your company’s profitability.